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SUMMARY
1. This study is an evaluation of ERFD supported venture capital and loan funds in Scotland, including the Scottish Co-Investment fund. The study provides a fund level performance appraisal, and information on the effect on companies in which the fund has invested. It also considers the economic effect of the funds and the affect on the market for finance in Scotland.
2. The study is based on surveys and interviews mainly carried out in 2006, although certain data in the main report has been updated during 2007.
The policy background
3. Access to risk finance is important to the development of SMEs, but early stage financing is often less attractive to commercial investors for a number of reasons. For example, a bank may be unwilling to provide finance to an SME because of a lack of a track record, inadequate security, breach of a standard threshold limit, or a credit rating outside an acceptable range. In addition, as the size of investments falls, so the costs of administering investments become relatively more significant. There is therefore a potential failure of the market to provide for the financing needs of SMEs at an early stage.
4. The policy response at both EU and national level has been to seek to develop of cost-effective means of addressing this potential market failure. The development of measures such as revolving loan funds and venture capital funds has been encouraged at both a national level and by the European Commission as an alternative to grants. Across the EU, during the 1994-99 ERDF programming period, VCLF measures accounted for some €570m and this had doubled to an estimated €1,256m in the 2000-06 period. The Regulations for the current (2007-13) Structural Fund programming period continue this emphasis. In addition, there are specific arrangements for VCLFs to be managed by the European Investment Fund ( EIF) in the current programming period if Managing Authorities so request.
5. ERDF supported VCLF instruments have been made available in Scotland during both earlier Structural Fund programming periods and continue into the 2007-13 period. Based on an assessment in 1995/96 that there was a continuing market failure in the supply of debt funding up to a level of £250,000, three funds were established. And an evaluation carried out in 2002 found that they "had facilitated better business propositions and ensured larger turnovers than would otherwise have been achieved".
Fund Covered by this Evaluation
6. During the 2000-06 programming period, a number of new funds were established and it is mainly these funds that are the subject of this evaluation (although some funds, like WSLF and DSL were established earlier). The funds include both loan and equity funds. Equity funds, in turn, include both directly managed funds, where the fund is under the control of a professional investment manager, and a co-investment fund, where the fund appoints private sector partners who introduce deals.
7. The table below summarises the objectives, type of investment (equity or loan), the maximum fund investment level, and the geographical coverage (highlighted) of each of the VCLFs covered by the evaluation.
Overview of VCLFs
In addition, there are several other funds which do not take on new business because they have been revolved into one of the above funds.
The market for finance
8. The four ERDF-supported venture capital funds (the top four in the table above) have total public sector resources of just over £50 million for the current programming period. On the assumption that these are invested over a 3 or 4 year period, average annual public sector input is in the region of £13 million to £17 million (clearly, in some years the amount is higher), compared to annual venture capital investments in Scotland which vary between £100m and £400m, depending on economic conditions. The ERDF-supported funds therefore play a relatively small part in the market overall. However, they play a significant role in early stage financing and an analysis of deals commissioned by Scottish Enterprise has confirmed their importance.
9. The loan funds covered in this evaluation can lend approximately £4 million per annum. These funds are small in relation to the market as a whole and are therefore unlikely to displace other lenders.
Conclusions
10. We now summarise the main conclusions of the evaluation under the headings of relevance, effectiveness, coherence and synergies, impact and added value and sustainability. A brief explanation of each of these issues is also shown.
Relevance (The extent to which the fund objectives are relevant to economic development in Scotland given policy priorities and the key issues relating to the prevailing economic and financial environment generally).
11 Most VCLFs undertook an assessment of the market in the areas they intended to operate in, as part of their set up process. The conclusion of these assessments was that a market failure existed and that some public intervention was necessary to ensure a supply of loans or risk capital to enterprises in Scotland.
12 The research we have carried out confirms the view that ERDF-supported VCLFs have addressed areas of continuing market failure. Discussions with the financial community, and with the investment partners of SCF, suggest that the decline in availability of venture capital in Scotland arising from the effects of the 'dotcom bubble' continues. The investment partners of SCF whom we have talked to consider that there is a market failure above the level at which SCF now operates. Most partners said that the investment limit of SCF should be increased, possibly to £5 million, or another vehicle put in place to cover that part of the market. The recent launch of the Scottish Venture fund provides such a vehicle.
13 It is clear that the co-investment fund model helps develop the local financial community. Discussions with investment partners include the major business angel syndicates who commented on the beneficial effect of SCF on their operation. The availability of public sector match funding increased the deal capacity of syndicates. Coupled with other public assistance in the running of syndicates, the result has been a strong syndicate network, particularly in the East of Scotland, with newer developments in the West. And some of the investment partners of SCF were not previously involved in company finance in Scotland.
14 In respect of SCF, additionality can be considered both from the point of view of the enterprise in which the investment is made, and from the point of view of the investment partner. Investment partners of SCF only bring to SCF the share of those deals which they cannot finance themselves. The reason for bringing deals to SCF is often a lack of financial capacity to meet the whole of the deal, or a desire to spread risks. Such reasons imply additionality - the deals would not be entered into fully if SCF was not there. From the point of view of the enterprise, the structure of SCF makes it more difficult to measure additionality using normal techniques. This is because the enterprise will typically approach a number of private sector funders and from its point of view the effect of SCF is to improve the demand side, rather than to provide a "lender of last resort".
15 The survey evidence suggests high additionality from SCF. Our survey of investee companies showed that no other funding was available (28%) or that whilst some other funding was available more was needed (64%). In most cases companies said that their investment could not have gone ahead without funding (25%) or would have gone ahead on a smaller scale (70%). The number of investments in the other equity funds is small but the survey evidence on additionality, based on the small numbers, shows a similar position.
16 Loan funds seek to operate on a lender of last resort principle. Their application procedures include a requirement that the lender should demonstrate that they have sought commercial funding and have not obtained such funding. To this extent, the additionality of investments by loan funds should be high because the funds are making loans which would not otherwise be made. Most previous evaluations of the various loan funds have shown high levels of additionality, although a small survey of So SLS investee companies showed lower additionality. For example, an external evaluation of WSLF suggesting that additionality exceeded 70% and high levels of additionality were also supported by our surveys. For example a small survey of PSYBT showed full and partial additionality in 13 out of 14 cases.
17 The issue for the loan funds is to find investments which are of sufficiently high quality so that they are likely to be able to meet repayments, but not so high as to include enterprises which could be financed commercially. Most loan funds take security (even if it is just a floating charge) and their terms are marginally better than commercial lenders. The loan funds could increase additionality by taking on worse risks - but this may be at the expense of the sustainability of the fund. Additionality, by itself, may not be a good measure without an understanding of the investment policy of the fund.
18 All VCLFs have explicitly addressed the issue of displacement in their ERDF funding applications to demonstrate how they comply with state aid rules. Displacement can take place at various levels. The setting up of ERDF supported VCLFs may displace existing providers of such funds and the provision of public funding to enterprises may displace competitors who do not receive such funding. The latter point is, however, covered by EU state aid rules.
19 The structure of the venture capital funds set up under ERDF funding means that it is unlikely that significant displacement effects will occur.SCF, for example, is likely to enhance the market rather than to displace other providers because it only invests in deals that are brought to it by other venture capitalists. Indeed, if SCF is financially successful, it may have a demonstration effect which could encourage venture capital firms to return to the Scottish market. A similar position exists for the other larger funds, in particular the Sigma funds, which are invested in conjunction with existing providers.
20 In respect of loan funds, the policy is to concentrate on lenders who have not been able to obtain funding from any other source. As indicated above, it is a specific requirement of these funds that the applicant is able to demonstrate that he has not been able to obtain funds elsewhere. As a result, it is unlikely that there will be significant displacement effects towards other loan providers since those other providers obtain a chance of the more attractive deals on a commercial basis.
21 At a company level there is more likelihood of displacement by loan funds than equity funds. Most of the equity funds invest in early stage businesses, generally in new markets. In such circumstances there is less likelihood of displacement at the company level, because markets are growing. On the other hand, the loan funds often lend to established businesses, later in their life cycle. For these investments, the likelihood of displacement of a competitor is higher. But we do not have evidence on actual levels of displacement.
Effectiveness (The extent to which the funds are achieving their targets. There are a number of critical factors in this respect - the quality and quantity of resources, the extent to which outcomes are relevant (see above), how effectively the funds meet their objectives).
22 The VCLFs all have targets for the rate at which they invest funds, in particular ERDF funding where there are time constraints. The rate of investment of SCF is lower in the West of Scotland than in the East. Because ERDF funding has been provided to SCF for venture capital purposes, it cannot be decommitted. If the investment allocated to SCF is not utilised by the end of 2008, then there is a danger that some ERDF funding may be lost. In the South of Scotland, the planned funding to be allocated to SCF was reduced from £2 million to £1.5 million, but in the West of Scotland the commitment has taken place and cannot be reversed.
23 SCF recognises the need to increase the deal flow in the West of Scotland and commissioned a study to consider the reasons for the low deal flow. An important recommendation was that investment readiness of companies should be improved, and that in particular links between advisers and SCF should be improved so that there is a larger and better deal flow from the advisers.
24 The West of Scotland based loan funds have generally met their investment targets, although the targets increase over time and substantial funds remain to be invested. Updated information suggests that for WSLF, commitments are failing to meet these increasing targets.
25 In the South of Scotland, there has been some decommitment of money made available to loan funds and it is understood that a further decommitment is planned. As noted below, the main loan fund now operating, SEBSED, has a substantial cash balance. We consider separately the economic effects of the funds later in this section.
Economy and Efficiency (The costs of managing, administering and operating the funds and whether the resources used to operate the funds could be used more efficiently to produce similar results at lower costs).
26 The operational costs of the loan schemes appear at first sight much higher than those of the venture capital schemes. The loan schemes' direct costs are in the region of 10% to 15% of gross new loans and in addition some external support is provided by local authorities and Business Gateways. The deal size of loans is, of course, much less than that of the venture capital funds.
27 The direct annual costs of the venture capital funds are in the region of 3% to 6% of gross investment. Costs for SCF are higher in the initial stages because of the fee of 2.5% or 3.5% paid to partners. As the fund is fully invested, costs should drop. For Sigma managed funds, it must be appreciated that these costs will continue over the life of the investment. An annual fee of 3% will amount to approximately 20% of gross investment for an investment held for (say) six years. The SCF model appears to be cost-effective from a management point of view.
Coherence and synergies (From an internal perspective, how funds relate to other public sector and private initiatives. Externally, the question is the extent to which there is overlap between funds, or the degree to which particular markets are not met by them).
28 The portfolio of VCLFs supported by ERDF funding includes the provision of risk capital through equity funding:
- Equity funding, up to a deal size of £2 million, throughout Scotland
- Risk capital funding, at start-up or proof of concept stage, in the East of Scotland
- Loan funds, directed at existing and new businesses, in the West of Scotland
- Loan funds directed at growing businesses, in the South of Scotland
- Specialist funds, including Micro credit in the East of Scotland and a small element of finance for young people.
29 It is clear that there are gaps in the funds that are being offered. When we carried out our fieldwork in 2006, the gaps included equity funding above the £2 million deal size level. This gap has of course been addressed to a large extent with the launch of new funds at the end of 2006. There are also geographical gaps in the provision of general loan funding in the East of Scotland, and micro finance, although our work did not provide evidence of unmet demand for general loan funds or micro finance.
30 In terms of the coherence of the various funds, it is necessary to consider whether there is any displacement effect between the funds, for example between some of the loan funds and the venture capital funds or between loan funds. There is clearly some overlap between WSLF and WSRF, although there appears to be adequate demand for their loans. To consider a possible overlap between WSLF and SCF, we looked at the sectors in which each invests and the size of the investments. This analysis did not suggest any significant overlap.
Impact and added value (What effect the funds have overall on the Scottish economy).
31 The ERDF-supported funds play a relatively small part in the Scottish market overall, both in respect of loan financing and equity financing. However, they play a significant role in early stage equity financing, where the total market in Scotland has averaged about £20m per year in the period covered by this evaluation. In that context, SCF's total public sector resources of £43m (not all early stage) are significant.
32 Overall, the funds considered in this evaluation have invested in more than 350 new businesses, 700 existing businesses and created more than 5300 new jobs. But as indicated above, a more important long term effect is likely to be the development of the financial community, particularly the development of angel syndicates and the encouragement of new lenders to enter the Scottish market
33 All funds which are supported by ERDF funding have a series of targets which correspond with the requirements of the ERDF. These targets include various measures related to the horizontal themes in ERDF funding for the current programming period, for example equal opportunities. They also include more general targets, in particular targets such as the number of new businesses receiving support, existing businesses receiving support, number of jobs created, number of jobs saved and increases in turnover of businesses. However, these targets are not necessarily appropriate to fund investing for the long term in hi-tech companies.
34 It appears that the equity funds have a greater effect on turnover and the loan funds have a greater immediate effect on jobs. This result would be consistent with the targets set for the different types of fund. At this stage it is not possible to estimate a cost per job or unit of turnover. However, for the equity funds, to the extent that they are profitable, such a calculation is meaningless because there is no 'cost'. The loan funds have made estimates of investment per job, in the region of £6,000 - £7,000 for WSLF. Again, because of the recycling effect, the cost will be nil or small.
Sustainability (Whether the funds are likely to be self-sustaining in the longer term without the need for continuing public support, or with lower amounts of public support. Given the relatively early stage of development of some funds it may be difficult to arrive at conclusions in this area at this stage).
35 One of the principles underlying the creation of loan and risk capital funds using ERDF money is to create sustainable funds. Several of the loan funds - in particular the WSLF and SEBSED have substantial cash balances. It appears that those cash balances are sufficient for the funds to operate for some considerable time without further public funding.
36 Other funds are at an earlier stage and it is not yet clear from outcomes when or whether they will be self-sustaining. The target rates of return for SCF of 20% would strongly suggest that this fund should become self-sustaining in the long term. However, it is too early in the fund's life to know whether this will in fact occur. The fund has incurred losses on some initial investments and at the beginning of August 2006 seven companies had ceased trading, representing some 6% of SCF investments to date. Such a rate of loss is not unexpected at this stage and not yet out of line with the results of other funds.
37 SCF is under-committed in the West of Scotland until the end of 2008 (the issue is the availability of deals), so it will not need immediate new funds from the next programming period in those areas. Typically, realisations from the initial investments might provide cash flow 6 to 10 years after investment. So there is a period during which SCF is likely to require some further support from the next round of ERDF financing to sustain its planned rate of operation.
38 Many early stage funds, and micro loan funds, are less likely to be self-sustaining because of the relatively high cost of administration relative to the sums invested. A recent survey by DGECFIN at the European Commission showed that over 10 years, European early stage funds had an IRR of only 1.3% (the figure over 20 years was 1.9% and in earlier years it was negative). It is likely that such funds will require further support to continue.
Recommendations
39 Our recommendations are divided into policy recommendations, in respect of the future of the VCLFs, and more specific recommendations relating to the operation and management of the funds.
Policy recommendations
40 We suggest that the primary focus of future funding should be directed at the following areas:
- Providing funding for the continuing operation of SCF, or alternative venture capital funds, subject to satisfactory financial performance which should be monitored as shown below. If the fund meets its targets it should become self-sustaining after the 2007-2012 period of ERDF funding.
- Providing funding, subject to other priorities, to cover the gap between the £2 million and £5 million deal size levels (during the period of our work, another planned fund in this area was launched).
- Continue to provide finance to special groups such as PSYBT, where results appear good.
41 To allow funding to be concentrated on good prospects which are likely to help the Scottish economy, geographical restraints on the allocation of funding should be removed. We understand that this is consistent with the proposals of the next period of the regional funds programming.
42 A lower priority should be given to the provision of further money into loan funds. These loan funds have, in several cases, now reached the stage where they appear to be self-sustaining. Should the funds cease to be self-sustaining, the issue should be looked at again and a comparison made of their costs against alternatives.
43 The report also contains a number of specific recommendations
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